Canadian Credit Health Update

2011-09-19

Introduction

These Canadian Credit Health Updates
are released every quarter. In these reports, I apply the same
analysis techniques that I used when watching the American financial
system through 2005-2009. If American and European-style problems
develop in Canada, I expect that these metrics will show early
warning signs just as they did in the USA. All data comes from public
financial reports (bank web sites and OSFI web site).

Off-balance sheet derivative exposures
will be included in some reports.

Summary
for 2011.Q3

TD
and Scotiabank currently have the worst loan books (by impaired
loans), but they did improve versus last quarter.

TD
is increasing leverage (and in fact has the most leverage) while
they have one of the worst loan books. This is potentially
dangerous and brings the risk of very sharp losses. Average
bank leverage is unchanged.

Royal
Bank is in the process of selling substantially all U.S. regional
banking operations to PNC Financial. They're taking a loss of $1.6
billion and the U.S. bad loans are eliminated from their impaired
loans (unless the sale fails approval and finalization). As a
result, Royal now shows virtually nil bad loans in the USA and their
loan book metrics have improved. This is good.

BMO
added significant U.S. loans ($29 billion) this quarter from
the acquisition of M&I. At the same time, BMO's gross impaired
loans have been restated to omit bad loans from purchased
U.S. loans. BMO says that the current figures have been adjusted to
reflect future expected losses. The flip side is that if U.S. loans
go sour, BMO's loan book will rapidly deteriorate: their U.S. loan
risk has increased.

Total
Canadian bankruptcies are stable at 2007 levels. There is no sign of
escalating bankruptcies.

Why watch these numbers?

In the modern economy, credit is the
key factor. Credit (loan) quality ties directly to bank health and
can indicate problems long before a bank is pushed to the brink of
insolvency. But this isn't just about bank health and safety of
deposits. Loans backed by real estate collateral underpin balance
sheets throughout the economy. This means that loan quality problems
translate into losses at banks, business, households, and the
national Treasury (for example the US Government pays Fannie Mae's
ongoing mortgage losses). On top of this, impacts of credit are
amplified through leverage,
both personal and bank. Canada is very highly leveraged, and this is
why we need to watch the situation.

Big Five
Bank Data

A.
Gross impaired loans / Gross loans (higher = worse loan book):
A rough measure of how
bad the loan book is. Before 2008, these values were under 1%.

Bank

2011.Q3

2011.Q2

2011.Q1

2010.Q4

2010.Q3

Royal Bank

0.79%

1.31%

1.54%

1.65%

1.68%

CIBC

0.91%

0.92%

0.98%

0.99%

1.09%

BMO

1.11%

1.58%

1.71%

1.80%

1.78%

TD

1.32%

1.34%

1.43%

1.23%

1.24%

Scotiabank

1.38%

1.43%

1.47%

1.50%

1.86%

Average

1.10%

1.32%

1.43%

1.43%

1.53%

B.
Gross impaired loans / Total assets (higher = worse balance sheet):
A quick measure of deterioration on the asset side of the balance
sheet. In the USA, banks started having major problems at 1.5%, and
critical problems including insolvency above 2.0%.

Bank

2011.Q3

2011.Q2

2011.Q1

2010.Q4

2010.Q3

Royal Bank

0.32%

0.55%

0.65%

0.69%

0.71%

BMO

0.48%

0.68%

0.74%

0.78%

0.79%

CIBC

0.49%

0.45%

0.50%

0.52%

0.58%

TD

0.60%

0.62%

0.66%

0.56%

0.55%

Scotiabank

0.74%

0.74%

0.80%

0.84%

1.03%

Average

0.53%

0.61%

0.67%

0.68%

0.73%

C.
Gross impaired loans / Tier 1 capital (higher = worse balance sheet):
This measure is very similar to the Texas Ratio, and compares the bad
loans to adjusted Tier 1 (Basel II) capital, the core measure of bank
capital which is primarily equity. If bad loans are a large % of the
bank's capital, it means the bank can not easily absorb the losses.

Bank

2011.Q3

2011.Q2

2011.Q1

2010.Q4

2010.Q3

Royal Bank

6.9%

11.6%

13.9%

14.7%

15.0%

BMO

9.4%

12.7%

14.3%

14.9%

14.7%

CIBC

11.1%

11.1%

12.0%

12.4%

13.5%

TD

15.0%

15.2%

16.1%

14.2%

14.1%

Scotiabank

15.3%

16.0%

17.1%

17.5%

21.6%

Average

11.5%

13.3%

14.7%

14.7%

15.8%

D.
Tier 1 Leverage ratio (lower = more leverage):
This doesn't measure loan quality, but rather the bank's leverage and
aggressiveness. Tier 1 leverage = tier 1 capital / total assets. This
measure is included because higher leverage translates to greater
overall risk. The banks with the worse loan books (above tables)
should exhibit lower leverage, otherwise it means they are being far
too aggressive for their condition.

Bank

2011.Q3

2011.Q2

2011.Q1

2010.Q4

2010.Q3

BMO

5.1%

5.3%

5.2%

5.3%

5.3%

Scotiabank

4.9%

4.7%

4.7%

4.8%

4.8%

Royal Bank

4.7%

4.7%

4.7%

4.7%

4.8%

CIBC

4.4%

4.1%

4.2%

4.2%

4.3%

TD

4.0%

4.1%

4.1%

3.9%

3.9%

Average

4.6%

4.6%

4.6%

4.6%

4.6%

Bankruptcy
Statistics

These
numbers lag by a full quarter, but they are still valuable: this
shows total Canadian bankruptcies over time. Bankruptcy rates closely
relate to bank loan quality. Note however that banks with significant
US/international operations have further credit exposure beyond
Canada.

Bankruptcy
rates are virtually unchanged in recent months. They are still at
pre-crisis (2007) levels.